Commercial property: ready for a rebound?
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Associate Editor
David Stevenson Mar 27, 2009
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"Commercial property is a dirty word for many investors," says Investors Chronicle. And it's little wonder – since January 2007, when most of Britain's major commercial property companies converted to real-estate investment trust (Reit) status, the UK Reit index has plunged by 76%, undershooting the FTSE All-Share by almost 60%. Commercial property valuations, meanwhile, have dropped by 40% since June 2007. But surely after those sorts of falls there must be some value in the sector? Mike Prew at Nomura reckons "there appear to be some signs of the cycle reaching a market bottom for top-quality assets... providing the leases are long enough to see them through to the end of the rental recession".
The trouble is, this is quite a big proviso. Rent levels are a vital component of building valuations. The UK commercial rent picture already looks pretty grim. The latest data from the Investment Property Databank (IPD) – the commercial property value bible – showed rental values falling by an average 0.93% in February. There were falls across the board, with offices hit particularly badly with a 1.74% monthly drop. With Britain's dole queues now at the two million mark and lengthening at their fastest pace since records began, prospects aren't looking up.
Job losses mean less demand for workspace. Within the next year, total layoffs in Britain could double, says David Waller, chairman of recruiter Network Holdings – unemployment "could reach four million early next year". This spells trouble for landlords. More premises will fall vacant as companies cut back or are forced out of business. Lease negotiations will also get trickier. To make matters worse, landlords must now pay business rates on many of their properties that stay empty for more than three months.
Rents "will become the dominant downward influence on capital values this year", says Capital Economics. The consultancy warns that "there's a growing risk that all forecasters, including us, have significantly underestimated the scope for rental value falls".
This fact is reinforced by last week's downbeat data from other forward indicators – 2008's fourth-quarter merger and acquisition (M&A) and construction activity. Despite the former being boosted by the UK government buying a majority stake in Royal Bank of Scotland, deal volumes were still down 27% year on year. Meanwhile, the CIPS/Markit construction index "suggests developers could now be 'factoring in' all-property rents falling at 10%-12% annually by the third quarter of 2009", says Capital Economics's Kelvin Davidson. "With the occupier market only in the early stages of a major downturn, we expect all property rental values to decline by around 10% both this year and next."
In other words, commercial property prices could fall faster, and further, than currently forecast. This means that many loans made by the banks on commercial property purchases over the last few years will be "worth more than the properties they're secured on", says Investors Chronicle. That's why those banks have been forced into making huge write-downs – with more in store. And as most property advances include a loan-to-value (LTV) covenant, which requires borrowers to top up their equity if valuations fall below specified ratios, there could be plenty more trouble ahead.
De Montfort University research shows that £76bn of debt secured on commercial property will need refinancing by the end of 2010. With lenders ever warier of lending on bricks and mortar, it's no surprise to see several UK Reits rushing into raising extra cash via a spate of rights issues. The 'majors' – Land Securities, British Land, Hammerson and Segro – have tapped shareholders for £2.7bn of "restorative equity", while Liberty International is expected to follow shortly. But this isn't an option for every Reit. Industrial property owner Brixton has seen its shares fall more than 95% since the start of 2007, and has now been placed by Fitch on 'Rating Watch Negative' as there's "major execution risk" associated with a share placement. In short, it's a non-runner.
Further, rattling the tin towards the stock exchange isn't an option for non-quoted businesses. Insolvency specialist Begbies Traynor reckons that 1,600 private property companies could go to the wall this year. That all means much more supply hitting an already saturated market. "The key event is what will happen when one of the Reits breaches its LTV covenants," says John Cahill at KBC Peel Hunt. "The banks can't sell property any easier than the real-estate companies, and they won't want it on their balance sheets." He sees this as a bullish sign. "We're not a million miles off bottom. Real-estate shares have always been a lead indicator, and once the bad news is out of the way, we may well see a relief rally."
Indeed, as Peter Bill points out in the Evening Standard, shares in British Land have recovered 25% this month after its recent cash call. But we suspect that this will be a short-lived bounce. With the outlook for Britain's economy darkening even further – last week the International Monetary Fund warned that Britain faces the most brutal economic contraction since World War II, continuing well into next year – the prospects for both commercial property prices and Reits look very bleak for many months to come.
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